The advent of electronic trading in the 1990's brought a
faster dimension to the trading experience when it began to replace the system
whereby traders on the floor of exchanges would buy and sell by shouting orders
at one another. As improvements in technology accelerated the speed of
communications and made transaction processing ever more efficient, so more
traders opted to go this route, and today it is the rule rather than the
exception.
By the late 90's electronic trading had also become
available to the little guy - the retail investor. In America 20% of the
population took advantage, compared to 5% ten years earlier. The man on the
street could participate easily, and also relatively cheaply.
But retail investors have a minimal impact on market
movements, because the vast volume of traffic goes through institutional
investors, banks, hedge funds, private trading firms and exchanges, all trading
with one another. And they've always had the advantage over the little guy,
just by getting their orders filled faster, and by being closer to the action.
The use of electronic trading sped up the process from day one for everybody,
so where does high speed trading fit into the mix today, and why has it become
suddenly so controversial?
High speed (also known as high frequency) trading utilises
fast processors and fibre-optic communications lines to place multiple orders
that are transacted incredibly quickly (in milliseconds) to get in and out of
the market at a rapid rate. They take advantage of even small price
differentials to make small profits, but by placing millions of transactions
these profits add up to significant amounts. The principle behind it all is one
of gaining advantage by being able to exploit these differentials ahead of
everyone else. The programs driving the trades consist of complex algorithms
that look for specific market conditions, which once found trigger a buy or
sell order, or sometimes a cancellation if this suits the purpose. Current estimates
put the volume of all current exchange trading by high speed traders at around
50%. And it's so profitable that a firm called Hibernia Networks is allegedly
spending $300 million to run a fibre-optic cable across the Atlantic to connect
Wall Street and the City, just that few milliseconds faster.
High speed traders say they bring benefit to the markets by
acting as market makers who provide enhanced liquidity, and by narrowing the
bid to offer spreads, thereby making market participation cheaper. They also
claim that it makes the market more efficient. Critics respond by citing the
opportunities high speed trading creates for manipulating the market. An
example of this often quoted is the practice of 'front running', where a trader
anticipates your order to buy a block of shares, and before you can place your
order he has bought in ahead of you, driving the price up. He then sells them back to you for a profit. Essentially
he's using his advantage in speed and volumes of transactions to drive a stock
down, then buy it back for later sale at a higher price.
This kind of behaviour generates an ethical argument. By
getting in first the high speed trader could be said to be acting on inside
information, which is not only unethical but also illegal. In fact, in April
the FBI announced that it was opening an investigation to establish whether
high speed trading firms are practising insider trading. The results should be
interesting, to say the least.
Another alleged practice is the detection of stop losses in
the market. The high speed trader once again takes advantage by selling to
trigger the stops, then profits when the price swings up again. So if you're a
small investor with your stop in the same place as thousands of other players,
some of whom are trading large volumes, your relatively trivial trade could be
taken out at the same time.
The complex and sometimes less than well tested algorithms
have caused market volatility way in excess of the norm. The so called 'Flash
Crash' of 2010, when the Dow Jones Industrial Average dropped 700 points in
minutes, was triggered by an algorithm executing a sell trade based on volume
and not price or time. Other high speed trading firms leapt in to buy, but then
tried to reduce their positions minutes later by selling. The original
algorithm then increased the volume of sell orders, and the market went into a
tailspin. At some point the original instigator must have pulled the trade, and
the market recovered by day's end. This kind of computer generated volatility
has caused controversy, and dents investor confidence.
So how does all of this affect the small investor? You could
argue that high speed trading damages our pension funds by anticipating and
profiting from the trades these funds make on our behalf. Or that our insurance
premiums are affected when Insurance companies suffer in the same way. Perhaps
the unexpected volatility caused by the odd flash crash adds an increased level
of risk to your trade, should you be unlucky enough to be in the market on the
day. Or maybe you'll suffer when your stop loss triggers as a result of a
market algorithm.
But the truth is, high speed traders aren't interested in
the little guy. They spend most of their time competing against each other, and
if they were to target retail trades the volumes involved would most likely be
too insignificant to be of interest. This doesn't mean that the retail investor
is immune to the high speed trading phenomenon. An algorithm is logical and
takes action unemotionally, which theoretically confers advantage over the
human being, who trades subject to fear and greed. I personally don't think
this should drive you out of the market, and especially not if you're holding
stock for the longer term.
If you want to know more about the high speed trading market
and the issues around it, you might like to read Michael Lewis's book - 'Flash
Boys', available on Amazon. Only recently released, it seems to have generated
plenty of controversy over the practice.
Darren Winters
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